Policyholders seeking insurance funds to settle a case often face an insurer’s demand that some amount should be allocated to uncovered claims or parties. The issue arises often under directors and officers liability (D&O) policies, when settlements resolve the liability of covered directors and the uncovered company. But general and professional liability and errors and omissions insurers also demand to allocate settlements. Suppose, for example, that a complaint alleges both covered negligent and uncovered intentional conduct. The policyholder receives a reasonable demand to settle the damages exposure, but the insurer argues that it should only have to contribute one-half of the settlement because one of the two bases for liability is not covered. How should you respond? Surprisingly, California courts have not clearly addressed the issue outside of the D&O context. But the rationale of the D&O cases, and the few cases to address the issue outside the D&O context, should cause policyholders to think carefully before agreeing to demands to allocate settlements.
For D&O policies, courts first recognized what has become known as the “larger settlement rule” in a 1990 case from Illinois, Harbor Ins. Co. v. Continental Bank Corp. The question there was how to allocate a settlement between the potential liability of the covered directors and officers, and of the uncovered company. The court observed that the policyholder could show that the settlement—viewed as to the covered directors only—would satisfy the insuring agreements of the policy. The insurer would then have to show some basis in the policy for reducing the amount it should pay on the grounds that the settlement would also release the uncovered company. The court therefore held that—absent language expressly addressing the issue—if the same dollars were paid to settle the potential liability of both the covered directors and the uncovered company, those dollars must be allocated to the covered claims against the directors. In other words, the insurer is liable for the entire settlement unless the insurer can show an amount, if any, by which the settlement was made larger because of claims against uncovered company. Because the same damages are usually being sought against both, and their liability is also usually joint, the insurer’s task becomes difficult at best.
Federal courts applying Washington and California law adopted the larger settlement rule for D&O cases in 1995. Other states have adopted it widely, though not uniformly.
While the larger settlement rule has mostly been applied in cases involving D&O policies, it has been applied to other insurance policies. In another federal decision applying California law in 2006, PMI Mortgage Ins. Co. v. AISLIC, the court applied the larger settlement rule to a professional liability policy in a case against a mortgage insurer. The court ruled that under the larger settlement rule, AISLIC’s policy covered the entire settlement because AISLIC failed to provide any evidence “to carry its burden of identifying, allocating, and quantifying, by dollar amount or percentage, any portion of the…settlement to any of the three exclusions it invokes.” That same year, in Peterson Tractor v. Travelers, a California federal court applied the same methodology, though not the rule expressly, to a settlement under a general liability policy.
The larger settlement rule is, by another name, the same rule and rationale applied by California courts addressing allocation of defense costs under general liability policies. In the 1997 case, Buss v. Superior Court, the California Supreme Court held that when an insurer seeks reimbursement of defense costs expended in connection with covered and uncovered claims, it can only recover “[d]efense costs that can be allocated solely to the claims that are not even potentially covered.” Payments that can be allocated jointly to both covered and uncovered claims “by definition…are fully attributable” to covered claims.
Buss’s holding that an insurer is obligated to pay all defense costs except those paid solely for uncovered claims applies equally to settlements. When an insurer is asked to fund a settlement that resolves liability for covered claims and parties, the insurer is merely doing what the policy requires: “the insurer has been paid premiums by the insured” and thereby “bargained to bear these costs.” If the insurer does not incur any additional cost to obtain a release at the same time of uncovered claims or parties, it should not obtain a windfall by seeking to “allocate” amounts that, as the court observed in Buss, were “required in any event.” Only amounts paid solely to settle uncovered claims should be allocable.
Notably, the California Supreme Court in a 2009 decision, State of California v. Allstate Ins. Co., addressed coverage for environmental damage that may have resulted from both insured and uninsured causes. The insurer argued that, unless the insured could show what amount of damage resulted from an insured cause, it could not recover. The court rejected that view and held that the burden was reversed. So long as the insured could show that the entire clean-up was necessitated by the contamination from insured causes, all of the clean-up costs would be covered. The burden would then shift to the insurer (because the insurer bears the burden of proof on its exclusions) to show what amount of the clean-up costs were attributable solely to uninsured causes. The court did not reach this result through the logic of Buss. Still, the same principle applies: If an amount is paid to settle covered claims (or to satisfy a judgment for covered claims), it remains covered even if the amount paid also resolves liability for uncovered claims.
It is therefore recommended to resist insurer demands to allocate settlements (or judgments) under any liability insurance policy without proof by the insurer that some amount was paid solely for uncovered claims or parties. Anticipating such a demand, it is important for the policyholder to work with defense counsel to evaluate—and communicate to the insurer as soon as possible—what the potential damages are under the covered and uncovered claims, or as against covered and uncovered parties. If they are the same, the policyholder should set expectations early that it will be looking to the insurer to fund any reasonable settlement. Even if the damages could vary, so long as a proposed settlement is a reasonable resolution of just the potential liability on the covered claims, then the insurer should fund it.